Textbook vision of the role of finance: Textbook vision of the role of finance

Textbook vision of the role of finance:

• Textbook vision of the role of finance:

• efficient allocation of capital
• optimal risk sharing

• Probably most workers instead view finance as:

• creating employment risk via corporate restructuring, bankruptcies, and financial crises
• enabling or spurring firms to maximize share value at labor’s expenses
• allowing bankers to earn astronomical bonuses, etc.

• The crisis has reinforced this negative vision of finance. Good time to think about this…

• How does financial development (FD) affect employment, wage and productivity growth?

• How does it affect the variability of employment?

• Does it magnify the employment losses at times of banking crisis?

For a start, consider case of identical firms

• For a start, consider case of identical firms

• 1-size continuum of firms with Cobb-Douglas technology:

• Entrepreneur has wealth A

• He can “steal” (at most) fraction 1 of revenues (net of wages: no stealing from workers)

• Better investor protection   more funding to firms (henceforth  = degree of FD)

• Competitive credit and labor markets

FD raises the response of employment to changes in:

• FD raises the response of employment to changes in:

• growth opportunities  : firms can better exploit them  hire more labor, offer higher wages
• initial cash flow A: it allows firms to lever more on its cash  hire more labor, offer higher wages

• This result hinges on firms being finance-constrained. True with CRS: firms always want to expand

• If there is an efficient scale K*, once firms are past K*:

• effect of FD abates as economy grows
• FD no longer affects employment response to cash-flow shocks

• We extend the approach by Rajan and Zingales (1998): FD should matter more for industries that are more “dependent on external finance”

• External dependence = reliance on external finance by U.S. listed companies in the Compustat database

• Baseline specification:

• Value added, employment and wage bill (Yj c): UNIDO INDSTAT3 2006 database, 1970-2003 yearly data for

• 28 three-digit-industries
• 63 countries

• External dependence (EDj): Rajan and Zingales (1998)

• Financial development (FDc):

• private credit/GDP
• stock market capitalization/GDP (1980–95 averages)

Extend model to 2 industries with different prospects:

• Extend model to 2 industries with different prospects:

• strong industry H with high expected profitability H
• weak industry L has low expected profitability L

• Labor flows freely between them: single equilibrium wage w

• Now FD affects not only total employment but also its distribution between industries – in favor of industry H !

• With higher FD, industry H attracts more funds than L:

• employment in industry H grows by more than in industry L
• employment in industry L may drop (if Ls is sufficiently inelastic)
• sufficiently high FD will eventually “shut off” industry L

With greater FD, sectoral growth shocks entail more cross-industry employment reallocations

• With greater FD, sectoral growth shocks entail more cross-industry employment reallocations

• But as FD proceeds, more and more firms achieve their efficient scale and become unconstrained:

• these firms stop reacting to cash flow shocks…

• As FD rises, it lowers the effect of cash flow shocks on job reallocations (eventually eliminates it)

Strategy: regress a measure of inter-industry reallocation on measures of

• Strategy: regress a measure of inter-industry reallocation on measures of

• FD
• FD  cross-industry dispersion of stock returns: FD should amplify response of sd to growth shocks but lower it to cash flow shocks

• where sd = cross-industry st. dev. deviation of Yjct (industry j’s growth in VA, L or w) in country c and year t

FD may become a handicap in a crisis because they create “dependence”: the more financial markets are trusted in normal times, the greater the damage to output and employment when a crisis hits

• FD may become a handicap in a crisis because they create “dependence”: the more financial markets are trusted in normal times, the greater the damage to output and employment when a crisis hits

• Most clearly seen by looking at liquidity provision: in normal times banks allow firms to save on liquidity  deploy more resources to production

• But when banks are hit by a liquidity shortage, the damage can be more severe

Two empirical strategies:

• Two empirical strategies:

• Kroszner et al. (2007): re-estimate Rajan-Zingales regressions before, during and after a financial crisis:
• 1 crisis observation per country, averaging crisis episodes for countries that experience more than one crisis
• Panel data approach similar to Braun & Larrain (2005):

• Financial crisis data from Laeven and Valencia (2010): universe of banking crises (1970-2009)

Financial development is associated with

• Financial development is associated with

• more employment growth, but only in non-OECD countries
• less employment reallocation (cross-industry dispersion of employment growth)
• but more employment reallocation in response to greater variability of shocks to growth opportunities (cross-industry dispersion of stock returns)

• Some evidence of a “dark side” of financial development:

• during crises, employment growth drops more in financially dependent sectors of countries with more developed financial markets